A Reappraisal of the Exchange Rate Determination: A Liquidity Approach

Yan Li, Xiangming Fang

Abstract

A dynamic general-equilibrium model with limited participation in financial markets is constructed to study the determination of nominal exchange rates in a small open economy with tradable and non-tradable goods. The qualitative and quantitative implications of this framework are assessed under flexible prices. Then, the panel dynamic OLS regression is applied to seek the empirical support for this liquidity-exchange rate model, a slight departure from the standard monetary-exchange rate model. The findings in the present paper shed light on the cointegration between the macroeconomic fundamentals and nominal exchange rates.

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